A federal court in Brooklyn, New York, rejected a defendant’s request to reconsider an earlier denial of his motion to dismiss an enforcement action against him by the Commodity Futures Trading Commission for fraud in connection with his alleged provision of virtual currency trading advice and discretionary trading of virtual currencies. The defendant had claimed that a subsequent decision in a California federal court related to a metals dealer supported the proposition that the CFTC has no authority to bring an anti-fraud case in connection with transactions involving commodities that are not derivatives, unless the CFTC alleges that a fraud-based market manipulation has occurred. Separately, the Securities and Exchange Commission sanctioned a broker-dealer for inadvertently deleting audio records of telephone conversations of eight salespersons subject to an SEC request, as well as for not properly documenting and maintaining records of some employees’ gifts and expenses. As a result, the following matters are covered in this week’s edition of Bridging the Week:

Broker-Dealer Fined US $1.25 Million for Inadvertently Deleting Audio Tapes Subject to SEC Request and for Not Keeping Accurate Records of Salespersons’ Expenses (includes Compliance Weeds1and Compliance Weeds2); and more.

Because of personal commitments, the next regularly scheduled edition of Bridging the Week will be August 6, 2018.

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Briefly:

Federal Court in Brooklyn Rejects Application of California Decision as Basis to Dismiss Pending CFTC Cryptocurrency Fraud Suit: A federal court in Brooklyn, New York, denied the request of Patrick McDonnell to reconsider its March 2018 rejection of his motion to dismiss a CFTC enforcement action on the ground that the agency has no authority to exercise enforcement authority over an alleged fraud involving cryptocurrencies, absent a claim of fraud-based market manipulation.

Earlier this year, the CFTC sued CabbageTech, Corp., a NY corporation, and Mr. McDonnell, its owner and controller, for unlawfully soliciting customers to send money and virtual currencies for virtual currency trading advice and for the discretionary trading of virtual currencies by Mr. McDonnell. However, alleged the CFTC, the defendants did not provide the promised services and misappropriated their customers’ funds. (Click here for background in the article “CFTC Files Two Enforcement Actions Charging Fraud in Connection with Cryptocurrencies Sale Schemes” in the January 21, 2018 edition of Bridging the Week.)

In response, Mr. McDonnell filed a motion to dismiss. The Brooklyn federal court denied Mr. McDonnell’s motion, holding that virtual currencies are commodities under applicable law, and that the CFTC has standing to sue persons for fraud in connection with spot sales of virtual currencies, even where such sales do not involve derivatives contracts. (Click here for background in the article “A Court, Treasury and the SEC Confirm Substantial Overlap in US Jurisdiction of Cryptocurrencies” in the March 8, 2018 edition of Between Bridges.)

In his motion for reconsideration, Mr. McDonnell asked the court to reconsider its earlier decision based on the outcome of a May 1, 2018, federal court decision in California involving Monex Deposit Company and other defendants. There, the court held that the CFTC cannot use the prohibition against persons engaging in any manipulative or deceptive device or contrivance in connection with the sale of any commodity in interstate commerce enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act to prosecute acts of purported fraud except in instances of fraud‑based market manipulation. (Click here for background in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week.)

In ruling against Mr. McDonnell in response to his request for reconsideration, the Brooklyn federal court noted that it “fully considered Monex and reaches a different conclusion.” The court said that, in its view, the relevant statute supported the CFTC’s standing to bring its enforcement action. (Click here to access the relevant statute, 7 U.S.C. § 9(1).)

The Monex decision was recently appealed by the CFTC to a federal appellate court in California. (Click here for background in the article “Expedited Federal Court of Appeals Review of Monex Lower Court Decision Requested by CFTC” in the June 24, 2018 edition of Bridging the Week.)

In other unrelated matters involving digital assets last week:

Ag Committee Considers Oversight of Digital Assets: The House Committee on Agriculture held a hearing on the regulatory challenges of digital assets. Among the persons testifying was Gary Gensler, former Chairman of the Commodity Futures Trading Commission and currently a senior lecturer at the MIT Sloan School of Management. Mr. Gensler argued that there “may be a gap” in the current oversight of cryptocurrencies that are not securities. He said that the current regulatory oversight provided through state money transmission regulations “is not satisfactory,” and, as a result, “Congress may wish to consider providing the CFTC – or another agency – with general authorities to write rules for [spot digital asset] markets, including possibly requiring registration for trading on crypto exchanges solely dealing in cryptocurrencies.” Separately, Daniel Gorfine, the CFTC’s Chief Innovation Officer and Director of LabCFTC, suggested that current regulatory frameworks might have to be reconsidered to accommodate digital assets because current frameworks center on “intermediaries or gatekeepers that manage the access to our markets or financial services activity.” However, new innovators are endeavoring to “disintermediate or substantially transform models” to enhance efficiencies. In response, Mr. Gorfine said that “regulators will need to proactively identify how rules and regulations conform or will need to change.” Last week, the House Financial Services Committee also held a hearing on digital currencies and the future of money.

Financial Stability Board Announces Framework to Oversee Digital Asset Markets: The Financial Stability Board announced a framework to monitor the financial stability implications of developments regarding digital assets. Although the FSB concluded that “crypto assets do not pose a material risk to global financial stability at this time,” it said there was a need for formally monitoring “in light of the speed of market developments.” The FSB said it will initially monitor metrics related to market capitalization, prices, and derivatives; banks’ exposure to digital assets; and correlations of volatility and between major digital assets and other asset classes such as gold, currencies and equities. Established in 2009, the FSB is an international organization comprising representatives of national authorities responsible for financial stability in material international financial centers that monitors and makes recommendations about the global financial system. (Click here for background on the FSB.)

NY Department of Financial Service Grants Another BitLicense: The New York Department of Financial Services granted BitPay, Inc. a virtual currency license (“BitLicense”) to offer clearing and settlement services to merchants that accept or issue payments in Bitcoin. DFS has now approved 10 firms for a BitLicense or a virtual currency charter. (Click here for background on NY’s Bitlicense in the article “NYDFS Issues BitLicense Framework for Regulating Virtual Currency Firm” in the June 5, 2015 edition of Bridging the Week.)

Jersey Issues Guidance on ICO Application Process: The Jersey Financial Services Commission issued guidance regarding the application process for persons seeking to conduct initial coin offerings from Jersey. The requirements will apply to all ICO issuers whether the digital asset may be considered a security under Jersey law. Among other things, the issuer must be incorporated as a Jersey company; prepare and submit to the Jersey Financial Services Commission an information memorandum (which could be a so-called “White Paper”) which complies with certain content requirements; ensure that any promotional material is “clear, fair, and not misleading; receive consent from the JFSC before undertaking any activity; and be subject to an ongoing audit requirement.

Legal Weeds and My View: A federal court in Massachusetts is expected to rule soon on a motion to dismiss made by Randall Crater and the relief defendants in the CFTC’s My Big Coin Pay, Inc. enforcement action filed earlier this year. In that action, the CFTC claimed that My Big Coin Pay, Inc. and two persons closely involved with the company – Mr. Crater and Mark Gillespie – allegedly engaged in a virtual currency scheme that misappropriated approximately US $6 million from 28 or more persons from at least January 2014 through January 2018. (Click here for background in the article “CFTC Sues Unregistered Company and Promoters of Fake Virtual Coin for Alleged Fraud and Operating Purported Ponzi Scheme” in the January 28, 2018 edition of Bridging the Week.)

Mr. Crater and the relief defendants argued in papers to support a motion to dismiss that the CFTC has no jurisdiction to bring its enforcement action alleging fraud in connection with the sale of the virtual currency known as “My Big Coin,” because the virtual currency was not a commodity under applicable law. This is because, said the defendants, the virtual currency was neither a good nor an article, or a service, right or interest in which contracts for future delivery are dealt in. If My Big Coin is not a commodity, the CFTC had no authority to prosecute a fraud case against them under applicable law, claimed the defendants.

Moreover, the defendants argued that the CFTC had no standing to bring a general anti-fraud case against them relying on a fraud-based manipulation prohibition adopted as part of Dodd-Frank. As did Mr. McDonnell in his request for reconsideration in CabbageTech, the defendants in My Big Pay Coin relied on the recent federal court decision involving Monex in proposing such an argument.

The CFTC disagreed with the defendants’ legal arguments, claiming that My Big Coin was either a good or an article, and thus a commodity, or in the alternative was a category of virtual currencies, like Bitcoin, for which futures contracts currently exist. In addition, the CFTC said that the reasoning of the Monex decision was flawed. The Commission claimed that the relevant law prohibited “any manipulative or deceptive device” (emphasis added), and rejected the federal court’s view that “or” should be read as “and.” (Click here to access certain defendants memorandum of law in support of their motion to dismiss; click here to access the CFTC’s response.)

In my view, a cryptocurrency may exist solely in digital form, but it is still likely a good or an article. As the New York Court of Appeals recently held in connection with source code, computer code stored on a computer takes up space on a drive. As a result, it must be physical in nature. (Click here for background on this NY Appeals Court decision in the article “Investment Bank Ex-Employee’s Conviction Upheld for Theft of High-Frequency Trading Algorithmic Code” in the May 6, 2018 edition of Bridging the Week.)

Broker-Dealer Fined US $1.25 Million for Inadvertently Deleting Audio Tapes Subject to SEC Request and for Not Keeping Accurate Records of Salespersons’ Expenses: BGC Financial, L.P. agreed to pay a fine of US $1.25 million to the Securities and Exchange Commission for inadvertently deleting audio files containing communications of eight registered representatives requested by the Commission and for not accurately documenting and maintaining records of various employees’ gifts and expenses. BGC is an inter-dealer broker registered with the SEC.

According to the SEC, in March 2014, SEC staff issued two requests for communications of the eight salespersons, including recorded telephone conversations. However, in 2013, BGC had updated its record retention policies to provide that digital audio recordings should only be maintained for one year. In response, BGC promptly began to delete existing dated audio recordings; however, no recordings of the eight salespersons were eliminated because of a prior litigation hold.

However, when the prior litigation hold expired in May 2014, audio recordings responsive to the SEC’s March 2014 request were inadvertently deleted because relevant BGC audio technicians were not advised of the SEC’s new request, said the SEC.

BGC discovered this situation shortly after the deletion and self-reported it to SEC staff.

Separately, the SEC claimed that, from 2014 to 2016, BGC sometimes did not properly document gifts and expenses of certain high performing registered representatives.

The SEC said that the firm did not reflect as compensation on its records season tickets for an unnamed New York sports team that were used personally by one salesperson, and sometimes reflected expenditures for two brokers as business expenses, when the relevant registered representatives failed to provide expenses reports with the names of attending customers or identified customers in attendance that were not present. Additionally, claimed the SEC, sometimes BGC reimbursed registered representatives for expenses, when in fact the salespersons were not present for the relevant activity; as a result, such expenditures should have been reflected on BGC's records as gifts.

Separately, BGC, on its own, determined that an expense administrator used a corporate credit card in another employee’s name to likely misappropriate US $1.3 million for personal expenses.

As a result of these episodes, the SEC said that BGC failed to keep and maintain accurate books and records of its expenses.

Unrelatedly, two US-based Deutsche Bank subsidiaries agreed to pay a fine of almost US $75 million in connection with their purported faulty handling of so-called “pre-released” American Depository Receipts. According to the SEC, the Deutsche Bank entities’ practices permitted pre-released ADRs to be used for impermissible practices, including inappropriate short selling and profiting around dividend payouts.

In January 2017, ITG Inc. agreed to pay a fine and disgorgement totaling US $24.4 million to settle charges brought by the SEC that it caused the issuance of pre-release ADRs since at least 2011 when it did not take reasonable steps to ensure that the concomitant number of the underlying shares were owned and custodied by the person on whose behalf ITG was acting, as required by SEC rule. (Click here to access the relevant SEC order.) Later last year, Anthony Portelli, a former managing director of ITG, agreed to pay US $100,000 to the SEC for failing to reasonably supervise personnel on ITG’s securities lending desk which purportedly resulted in the improper pre-release ADR practices. (Click here for details in the article “ Former Broker-Dealer Operations Head Charged with Supervisory Failure for Firm’s Improper ADR Handling” in the June 25, 2017 edition of Bridging the Week.)

An ADR is a negotiable certificate that ultimately evidences ownership of shares of a non-US company that have been deposited with a depository bank. In a lawful pre-release transaction, foreign shares have been purchased but not yet delivered to a custodian; in such circumstances, the shares must be owned and custodied by the person on whose behalf the pre-released ADRs are obtained.

Compliance Weeds1: The Financial Industry Regulatory Authority prohibits members and persons associated with members to directly give or permit to be given anything of value, including gratuities, in excess of US $100/year to any person associated with another person where such payment or gratuity “is in relation to” the business of the employer of the recipient of the payment or gratuity. This prohibition is not meant to preclude contracts for personal services. However, members must maintain a distinct record of all payments and gratuities in any amount and all contracts for personal services, and retain such records in accordance with ordinary SEC recordkeeping requirements. (Click here to access FINRA Rule 3220.) In September 2016, FINRA proposed to increase authorized gifts to US $175/person/year and to amend its gifts and non-compensation rules and interpretations. (Click here for background in the article “FINRA Proposes to Update Gifts, Gratuities and Non-Cash Compensation Rules; Recommends Gift Threshold Increase” in the August 14, 2016 edition of Bridging the Week.)

Similarly, the Chicago Mercantile Exchange and the Chicago Board of Trade prohibit members, member firms and broker associations and their employees from giving gifts or gratuities in excess of US $100/year to any employee of another member, member firm or broker association. Curiously, such prohibition does not exist for entities or persons that are solely members of the New York Mercantile Exchange and the Commodity Exchange, Inc. (Click here to access the relevant CME Group Market Regulation Advisory Notice.)

Compliance Weeds2: To minimize the likelihood of regulatory issues, registered entities need to think holistically. Important information that is not shared from one part of an organization with another often leads to regulatory problems. Broker-dealers have been sanctioned by the SEC and FINRA for failing to file suspicious activity reports to the Financial Crimes Enforcement Network of the United States Department of Treasury where there were red flags of potentially illicit customer behavior that touched different departments. (Click here for an example in the article “Two Related Broker-Dealers to Pay US $17 Million for Widespread AML Compliance Failures; Former AML Compliance Officer Also Sanctioned” in the May 22, 2016 edition of Bridging the Week.)

More Briefly:

CFTC Chairman and Chief Economist Respond to Vatican Paper on Ethical Considerations for the Present Economic-Financial System: In a rare Saturday publication of the Commodity Futures Trading Commission, Chairman J. Christopher Giancarlo and Bruce Tuckman, Chief Economist, responded to a recent publication by two Vatican offices that reflected on the morality of current-day markets and financial systems and proposed responsive ethical principles. The publication, issued by the two Vatican offices on May 17, 2018 – the Congregation for the Doctrine of the Faith and the Dicastery for Promoting Integral Human Development – generally challenged economic forces that, on the one hand, have increased economic well-being “with an unprecedented magnitude and speed,” but, on the other hand, have prompted “inequalities [to] proliferate between various countries and within them” and resulted in large numbers of persons living in “extreme poverty.” The offices were critical of derivatives generally and credit default swaps in particular, as types of financial products that contribute to speculative bubbles and had an “important contributive cause of the recent financial crisis.” (Click here to access the Vatican offices’ publication.) In response, Mr. Giancarlo and Mr. Tuckman respectfully reflected on the societal benefits of derivatives – providing a means for the risks of variable production costs “to be transferred from the those who cannot afford them to those who can,” thus helping to “stabilize the cost of day-to-day living.” While acknowledging “economic and ethical challenges” in CDS markets, Mr. Giancarlo and Mr. Tuckman argued that the markets provide an important benefit in today’s financial system by allowing market participants to hedge their business risks and, as a result, to “expand production, provide additional services, or increasing lending.”

SEC Augments Rules for Alternative Trading Systems: The Securities and Exchange Commission adopted amendments to Regulation ATS to, among other things, require certain alternative trading systems to file detailed public disclosures on a new form – Form ATS-N. The disclosures will include information on how an ATS operates, including order types; use of terms and conditions regarding conditional orders and indications of interest; segmentation of orders and trading interest and requiring notice regarding segmentation; fees; the ATS’s execution and priority procedures; and the sources and uses of market data. The objective of the SEC’s amended rules – which will be effective 60 days after their publication in the Federal Register – is to enable market participants to learn about differences that may exist between the treatment of subscribers and the broker-dealer operator and its affiliate, and to assess potential conflicts of interest. Compliance with the SEC’s new filing requirements generally must begin on January 7, 2019, or shortly afterward for an existing ATS. An ATS is a registered broker-dealer operated non-exchange venue that matches buyers and sellers of securities. (Click here for further details regarding the SEC’s proposal in the article “SEC Adopts New Form ATS-N and Amendments to Regulation ATS and Exchange Act Rule 3a-1 to Enhance Transparency and Oversight of Alternative Trading Systems” in the July 20, 2018 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman, LLP.)

CFTC Authorizes Clearinghouses to Invest Customer Funds in Certain Types of Euro-Denominated Sovereign Debt; Declines Identical Relief for FCMs: The Commodity Futures Trading Commission approved derivatives clearing organizations to invest customer Euro-denominated cash in French and German sovereign debt subject to various conditions. This authority includes the ability of DCOs to purchase and hold such debt outright, or to gain exposure to such debt through repurchase agreements. Among the conditions are that investment in French and German sovereign debt is limited to investments made with Euro-denominated customer cash; the two-year credit default spread of the relevant sovereign issuing the foreign sovereign debt is greater than 45 basis points; the dollar-weighted average of the time to maturity of the DCO’s portfolio of investments in each sovereign’s sovereign debt does not exceed 60 days; and a DCO’s direct investment in any sovereign debt does not have a remaining maturity of greater than 180 calendar days. No equivalent relief was granted to futures commission merchants to invest in the same French and German sovereign debt.

CME Disciplinary Committee Finds Member Engaged in Dishonorable Conduct by Entering Customer Order Without Authorization: A panel of the business conduct committee of the Chicago Mercantile Exchange ordered Coby Tresner, a member, to pay a fine of US $150,000, restitution of over US $105,000, an arbitrator award of over US $140,000, and be permanently barred from accessing all CME Group exchanges for entering customers’ orders on multiple occasions from December 2014 through March 2015 without authorization. Mr. Tresner’s actions purportedly caused the customers to sustain losses in excess of US $105,000.

ICE Futures U.S. Amends Block Trade Guidance to Permit Summation of Spread Trades on IFUS and ICE Europe to Count Towards Block Threshold: ICE Futures U.S. amended its Block Trade guidance to authorize block trades for two ICE exchange inter-commodity strategies where one leg includes an ICE Futures U.S. energy contract and the other leg includes an ICE Futures Europe energy contract and the sum of the quantities of the two legs exceeds the minimum threshold for block trades for the IFUS product. This relief is not available where one leg of a multi-exchange strategy involves an IFUS energy product and the other leg is an energy product on any exchange other than ICE Futures Europe, even if the two legs are highly correlated.

For further information:

Broker-Dealer Fined US $1.25 Million for Inadvertently Deleting Audio Tapes Subject to SEC Request and for Not Keeping Accurate Records of Salespersons’ Expenses:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of July 21, 2018. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or other employees.

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ABOUT GARY DEWAAL

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.